Relative Effects of Expansionary Monetary Policy

Relative Effects of Expansionary Monetary Policy on Macroeconomic Principles

The Reserve Bank will often use expansionary monetary policies during times when there is a contractionary output gap present in the economy as it encourages planned spending and increased output in the economy which closes this gap. In expansionary monetary policy the Reserve Bank can announce that they will be lowering the overnight cash rate through increasing the supply of money. If the Reserve Bank decreases the cash rate this means that banks will have an increase of money that they can invest and will therefore purchase open market securities such as bonds. An increase in the price of bonds will occur because of the high demand for bonds and this will cause a decrease in the nominal interest rate (i) as illustrated in figure 1.1 in the movement along the base money demand line (DM) from point a to point b.

Nominal Interest Rate (i)

Nominal Interest Rate (i)

S0M

S0M

S1M

S1M

Figure 1.1 – Expansionary Monetary Policy

Base Money (BM)

Base Money (BM)

BM1

BM1

BM0

BM0

i 0

i 0

i 1

i 1

a

a

b

b

DM

DM

In the short run the Reserve Bank can control the real interest rate (r) because inflation (π) is slow to adjust to overnight changes in the cash rate. We know that:

r = i - π

Therefore, any changes to the nominal interest rate will have an equivalent effect on the real interest rate. Expansionary monetary policy lowers the nominal interest rate, so the real interest rate will also be lowered briefly before inflation adjustment in the short term. In the longer term, the real interest rate is determined by the balance of saving and investment. Both consumption spending and planned investment spending incline when the real interest rate decreases, therefore a lower cash rate encourages investment and the marginal propensity to consume (MPC) will increase due to the increase in disposable income (Y-T). Exogenous factors such as government expenditure, exports and...